I made some major changes to municipal bond holdings again this week. Always a tough decision since they’re held in taxable accounts and thus it is a taxable event, but managing risk always trumps avoiding taxes.
While everyone is focused on the exciting stock market, it’s the bond market that is starting to worry me. Not that I’m expecting some sort of collapse in the near future, but the fundamentals are shifting greatly in favor of the borrower – which means against the lender/investor. When you see companies issuing billions in new debt, at record low rates, to finance one-time special dividends before the end of the year, you have to step back and think for a minute. If I were a company, I would borrow as much as I could at these rates too. But they’re not using the proceeds to finance new business ventures. They’re turning around and giving the money to their shareholders! I would think that what’s good for one party is not good for the other. If companies are cashing in on low rates (selling bonds at high prices), then I don’t want to be buying them. But we’re seeing the exact opposite! Billions continue to flood into the bond market every month. It puzzles me that people understand that it’s smart to borrow at low rates (refinance or take out a new mortgage), but at the same time they also want to lend…?
I realize that investors want yield and stability, but I think few see what’s happening. The lower rates go, the lower an investor’s future return and the greater the potential volatility (i.e. the return/volatility profile is being skewed against the lender/investor). You can thank the Federal Reserve for this. Their Quantitative Easing programs continue to push interest rates lower and bond prices higher. The way I see it, bond prices are being artificially propped up and it’s slowly becoming a game of “who will be left holding the bag?” Investors in bonds need to be asking themselves these questions:
- Can interest rates go lower?
- Will interest rates go lower?
- How long will interest rates remain at these levels?
- Am I being fairly compensated for the risk I’m taking by lending to this entity?
- What risks are there in lending to this entity?
- What risks are there on the horizon that could rattle the market for this type of bond?
It doesn’t appear that the game is about to end anytime soon but long-term investors should be wary if not managing bond volatility. Fortunately, corporations still have very healthy balance sheets so credit risk is not necessarily an issue for investment grade corporate bonds. This leaves you facing call risk (when a company buys back the bond to issue new ones at lower rates) and interest rate risk (which isn’t a huge concern as long as the game continues). Municipal bonds on the other hand, face interest rate risk, credit risk and now the concern that the government might actually change the federal tax exemption on municipal bond interest – let’s hope not! If we go over the daunting fiscal cliff, I would expect to see a sharp increase in volatility in muni bonds. If it occurs, I’ll be ready to take advantage. I think it pays to be cautious in the short-term. Opportunities lie ahead…
Thanks for following!
Nick